What the CFTC Rule Revisions Mean for Registered Investment Companies and Their Investment Advisers

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Vol. 19, No. 5 • May 2012 What the CFTC Rule Revisions Mean for Registered Investment Companies and Their Investment Advisers

By Michael Philipp, Sean Graber, Laura Flores and John O’Brien

ntil recently, advisers to registered investment companies 1 that invested in com-

modities and commodity-linked derivatives could expect to be regulated primarily

by the US Securities and Exchange Commission (SEC). They generally were able U to avail themselves of an exemption or fit within an exclusion that permitted them to avoid compliance with the bulk of the Commodity Futures Trading Commission’s (CFTC) regulatory regime. That division of regulatory oversight ended on April 24, 2012.

On February 8, 2012, the CFTC adopted registered investment companies that conduct new rules and amended existing rules2 that more than a de minimis amount of speculative now require commodity pool operator (CPO) trading in futures, commodity options, swaps registration by investment advisers operating and other commodity interests. This new regulatory regime overlaps with existing SEC regu- Michael Philipp is a Partner and Sean Graber, lations for mutual funds, resulting in a dual Laura Flores and Jack O’Brien are Associates framework of regulation that will lead to new in Morgan, Lewis & Bockius LLP’s Investment compliance challenges for mutual funds and Management Practice Group. Mr. Philipp is in Morgan Lewis’s Chicago office, Ms. Flores in its their advisers and other service providers. Washington, DC office and Messrs. Graber and Although the CFTC simultaneously O’Brien in its Philadelphia office. The authors effected other rule changes that affect advis- would also like to acknowledge the following col- ers to private funds that invest in commodi- leagues at Morgan Lewis who assisted with the arti- ties and commodity-linked derivatives, this cle: Tim Levin, Michael Piracci and Dana Westfall. article focuses on the modifications to CFTC Rule 4.5. Rule 4.5 has been relied on by most Consumer Protection Act (Dodd-Frank Act), mutual funds and their advisers as a defini- many “over-the-counter” transactions (that tional exclusion from being deemed a CPO is, swaps) were exempted or excluded from under the Commodity Exchange Act (CEA). most of the CFTC’s jurisdiction. The Dodd- Further, this article is designed to inform Frank Act expanded the CFTC’s jurisdiction, mutual funds and their advisers of how the particularly with respect to swaps and the recent changes to the CFTC rules will affect CFTC’s antifraud provisions. The CEA and them—including the proposed CFTC-SEC the authority of the CFTC, however, do not harmonization rules—and suggest how they extend to regulation of securities (except for might plan for compliance. Advisers to mutual security futures) or to commercial forward funds with a Rule 4.5 notice on file with the contracts that are settled by physical delivery. CFTC prior to April 24, 2012 will have until The CEA defines the term “commodity at least December 2012 to register as a CPO or pool” as any investment trust, syndicate or satisfy the de minimis trading thresholds. similar form of enterprise operated for the purpose of trading commodity interests.3 CPOs Background have been subject to CFTC regulation since the CFTC was created in 1974. As defined The CFTC, which regulates commodity in Section 1a(11) of the CEA, a CPO is any futures and swaps in the United States, admin- person engaged in the business of an invest- isters a comprehensive regulatory structure ment trust or similar form of enterprise who that governs accounts, agreements (including receives funds from others for the purpose of options), and transactions involving contracts trading commodity interests.4 Because inves- of sale of a commodity for future delivery tors in commodity pools are not obligated to (futures), swaps, as well as the entities involved respond to margin calls or personally settle in managing or advising funds that invest contracts and are generally not subject to per- in commodity interests (commodity pools). sonal liability, commodity pools have become Generally speaking, the CFTC has jurisdiction an attractive investment vehicle. In general, a over all futures contracts, options on futures CPO is the person or entity that organizes and contracts, and swap contracts on “commodi- promotes a commodity pool, has the author- ties,” as defined in the CEA. The CEA requires ity to hire and fire the commodity pool’s com- that futures contracts and options on futures modity trading advisors (CTAs), and selects contracts be traded on an exchange (desig- the commodity pool’s futures commission nated contract market) registered with and merchant.5 Because the sale of an investment regulated by the CFTC. Swaps that are deter- in a collective investment vehicle is the sale mined by the CFTC to be subject to a manda- of a security, interests in commodity pools, tory clearing requirement are required to be unless they qualify for an exemption, generally traded on a designated contract market or are subject to the provisions of the Securities swap execution facility, and clearing through Act of 1933 (1933 Act) and the Securities a derivatives clearing organization. Although Exchange Act of 1934 (1934 Act), whereas the term “commodity” is generally thought of CPOs themselves, unless exempt or excluded as applying to physical raw materials, such as from the definition of CPO, are required to agricultural items (for example, wheat, cotton, register with the CFTC and become members rice, livestock and corn), metals (for example, of the National Futures Association (NFA). copper, silver and gold) and energy resources The scope of regulation of CPOs has var- (for example, crude oil, natural gas and heat- ied over time. CFTC Rule 4.5 provides an ing oil), the scope of the CEA and the author- exclusion from the definition of CPO for per- ity of the CFTC extend not only to contracts sons operating entities regulated as registered on these raw materials but also to interest investment companies, banks, benefit plans, rates, currencies, broad-based stock indices, and insurance companies that meet certain and other tangible and intangible goods, and qualifications.6 Prior to August 2003, any of options on the foregoing. Until the adoption these regulated persons who claimed the Rule of the Dodd-Frank Wall Street Reform and 4.5 exclusion were required to represent to the

THE INVESTMENT LAWYER 2 CFTC that any commodity futures or options the definition of commodity interests, which contracts they entered into were for bona fide had the effect of including persons engaging hedging purposes7 and that the aggregate ini- in swap transactions within the definition of tial margin and/or premiums for positions that CPO set forth in the CEA. In January 2011, did not meet the bona fide hedging criteria did the CFTC proposed to return Rule 4.5 largely not exceed five percent of the liquidating value to its pre-2003 form. of a qualifying entity’s portfolio (after taking As amended on February 8, 2012, Rule 4.5 into account unrealized profits and losses). was returned to its pre-2003 state with respect Rule 4.5 further required that investments in to the requirements for registered investment these entities not be marketed as participation companies (but not for the other types of in a commodity pool or otherwise as a vehicle regulated entities), but with the addition of an for trading commodity futures or options. alternative test for “ de minimis ” investments. 12 Prior to August 2003, most mutual funds The CFTC noted in the Adopting Release, as chose to comply with these trading and mar- it had in the Proposing Release, that it was keting restrictions in order to avoid registra- concerned that funds were “offering de facto tion of the fund adviser as a CPO. commodity pools” and should be subject to In August 2003, as part of a larger overhaul CFTC oversight to “ensure consistent treat- of its regulation of CPOs and CTAs and based ment of CPOs regardless of their status with partly on the fact that such regulated entities respect to other regulators.”13 In particular, were already subject to extensive regulation the CFTC expressed concern about mutual by other regulators, the CFTC eliminated the funds’ increased use of derivatives because, in trading and marketing restrictions set forth in the CFTC’s view, such increased trading activ- Rule 4.5. 8 After these 2003 amendments, reg- ity may not have been appropriately addressed istered investment companies were effectively by the existing regulatory structure, includ- unlimited as to the amount of futures trading ing risk management and recordkeeping and they could undertake, so long as such invest- reporting provisions.14 ments otherwise complied with the regulatory framework of the Investment Company Act Trading Thresholds for Remaining of 1940 (1940 Act) (for example, Section 18 coverage requirements).9 Exempt from Registration The unwinding of the leverage bubble in To continue to rely on Rule 4.5, a regis- 2008, and the price spikes in oil and agricul- tered investment company will have to limit tural commodities in the summer of 2008, its investments in commodity futures, com- plus the advent of passive long-only invest- modity options contracts and swaps to below ment strategies in commodity interests by one of two thresholds. One of the thresholds a number of investment companies seeking requires that the fund’s aggregate initial mar- price exposure to commodities refocused leg- gin and premiums posted for its non-bona fide islative and regulatory attention on commod- hedging trading in these instruments must not ity and derivative products. Among other exceed five percent of the liquidating value of regulatory actions, the SEC commenced a its portfolio (after taking into account unreal- review of the use of derivatives by registered ized profits and losses and excluding the in- investment companies10 and the NFA peti- the-money amount of an option at the time tioned the CFTC to amend Rule 4.5 for the of purchase).15 As an alternative, the fund purpose of restoring the operating restrictions may limit the aggregate net notional value16 on mutual funds that were in effect prior to of its commodity futures, commodity options 2003. 11 In response to the market disruptions contracts, and swaps positions not used solely of 2008, the Dodd-Frank Act was enacted, for bona fide hedging purposes to no more which tasked the CFTC with defining and than 100 percent of the liquidation value of regulating swaps and other derivatives, includ- its portfolio determined at the time the most ing requiring most plain vanilla standardized recent position was established (after taking swaps to be exchange traded, cleared, and into account unrealized profits and losses). 17 reported. The Dodd-Frank Act also expanded This alternative de minimis threshold, which

3 Vol. 19, No. 5 • May 2011 was added by the CFTC in response to con- be beneficial for some funds with respect cerns from commenters that initial margin to complying with the trading thresholds, for certain commodity interest products may the swaps and forwards must be deliverable not otherwise permit compliance with the five in order to be carved out. In most cases, percent threshold, allows a fund to enter into mutual funds and ETFs use non-deliverable non-bona fide hedging transactions in these contracts to reduce the amount of cover- instruments having a net notional value equal age required for such contracts in light of to up to 100 percent of the fund’s net asset the SEC guidance regarding senior secu- value (NAV).18 In discussing its rationale for rities under Section 18 of the 1940 Act. the percentage limitations included in the two Additionally, the currency in many emerging trading thresholds, the CFTC stated that it markets may only be traded through non- views commodity interest trading in excess deliverable instruments. of these two trading thresholds as evidenc- Many industry participants are uncertain ing “a significant exposure to the derivatives as to whether the 100 percent net notional markets” that “should subject an entity to test is a reliable means to measure an entity’s the [CFTC’s] oversight.” 19 Despite requests exposure in the markets and the risks associ- from commenters to the contrary, a fund must ated with such exposures.23 Further, there is include its use of broad-based stock index a risk that this test may disproportionately futures, security futures, and financial futures affect certain types of funds because certain contracts in determining whether the fund derivatives strategies and instruments require meets the de minimis thresholds for exemp- a much higher notional value to have the tion. In addition, the CFTC expressly rejected desired result. For example, the implementa- a request to exclude from the two trading tion of an interest rate strategy in a bond fund thresholds funds that engage in a passive would generally require the use of futures strategy of index tracking.20 Had the CFTC with a much higher notional value than if adopted this passive investment carve-out, the fund was trying to gain exposure to the advisers solely to index-tracking exchange S&P 500 Index through the use of futures. 24 traded funds (ETFs) could have been able to Accordingly, funds that use strategies or avoid CPO registration.21 instruments that require high notional values One uncertainty in calculating the de may be disproportionately affected by the 100 minimis thresholds is the fact that the Dodd- percent net notional test notwithstanding the Frank Act entitles the US Department of fact that such funds may not pose a greater the Treasury (Treasury) to make a determi- risk to the markets. nation that certain currency-based deriva- With respect to the five percent trading tives are not “swaps” for purposes of the threshold, many in the industry feel that a CEA. In April 2011, the Treasury issued a five percent threshold does not reflect the proposed determination that would exempt realities of the current market in light of the foreign exchange swaps and foreign exchange fact that current margin levels for a number forwards from the definition of “swaps” of derivative instruments in which registered (Treasury Exemption).22 As a result, deliv- investment companies invest now exceed five erable foreign exchange swaps and foreign percent of contract value.25 As a result, funds exchange forwards that are physically settled may need to reduce their use of instruments would not be “swaps” and would not be with higher margin requirements for non- counted toward the de minimis threshold hedging purposes if they want to stay within for purposes of the Rule 4.5 exclusions. The the five percent trading threshold exemption Treasury Exemption would not exclude for- under Rule 4.5. eign exchange options, non-deliverable cur- These trading thresholds could also have rency swaps and non-deliverable forwards the unintended consequence of causing funds from the definition of “swaps,” so these to move away from the established futures instruments would remain subject to the markets and invest more heavily in structured Rule 4.5 trading thresholds. Although these notes, which are not subject to the trading carve-outs, if adopted by the Treasury, could thresholds, but which raise their own set of

THE INVESTMENT LAWYER 4 issues (for example, increased investment cost, CFTC Rule 1.3(z)(1). The new Rule 151.5 a limited number of issuers, and a lack of definition generally follows the Rule 1.3(z)(1) liquidity and price transparency). definition, with two significant differences. First, the new statutory definition recognizes Bona Fide Hedging Excluded from a position in a futures contract established to reduce the risks of a swap position as a bona the Trading Thresholds fide hedge, provided that either (i) the coun- As discussed above, a fund’s use of com- terparty to such swap transaction would have modity futures, commodity options con- qualified for a bona fide hedging transaction tracts, or swaps solely for “bona fide hedging exemption, (that is, the “pass-through” of purposes,” is carved out of the calculation of the bona fides of one swap counterparty to the two trading threshold exemptions under another (such swaps may be termed “pass- Rule 4.5.26 Although this may initially seem through swaps”)); or (ii) the swap meets the like a significant exception to the thresh- requirements of a bona fide hedging transac- old calculations, it is, in actuality, of very tion. Second, a bona fide hedging transaction little practical use because of the narrow or position must represent a substitute for a definition of “bona fide hedging.” Under the physical market transaction.30 CEA definitions, “bona fide hedges” must In light of the foregoing, in order to clas- effectively represent a substitute for trans- sify a position as a bona fide hedge for pur- actions in the cash or spot market, and do poses of Rule 4.5, a fund should undertake not extend to those types of risk mitigation a careful analysis of the type of instrument for which derivatives are commonly used by in question, the purpose of the position, the mutual funds to “hedge” certain exposures. position being hedged and the application of This is exemplified by the fact that, in the the relevant definition in either CFTC Rule Adopting Release, the CFTC warned that 1.3(z)(1) or 151.5. market participants should not construe the definition of “bona fide hedging” to permit Marketing Restrictions for Remaining a risk management exemption for purposes of determining compliance with the trad- Exempt from Registration ing thresholds in Rule 4.5.27 The CFTC’s Even if a fund can fit within either of the two declaration against risk mitigation was in trading thresholds so that the fund’s adviser direct contrast to requests from commenters can fit the exclusion from the CPO definition that sought to convince the CFTC to expand under Rule 4.5, the adviser would be unable to “bona fide hedging” to include positions rely on Rule 4.5 if the fund was marketed “as taken by mutual funds to offset risk in their a vehicle for trading in the commodity futures, securities or bond market positions or for commodity options or swaps markets.”31 In the cash equitization. Adopting Release, the CFTC included a list of In October 2011, the CFTC created a new factors that it would consider in determining definition of bona fide hedging for “refer- whether a fund was being marketed in violation enced contracts” pursuant to Section 737 of Rule 4.5, which included: of the Dodd-Frank Act.28 The “referenced contracts,” which include futures and options • The fund’s name; contracts on 28 physical commodities (for example, agriculture, energy, and metals), as • Whether the fund’s primary investment well as swaps that are economically equiva- objective is tied to a commodity index; lent to such contracts, are now subject to the definition of a bona fide hedging transaction • Whether the fund uses a controlled for- contained in CFTC Rule 151.5. “Excluded eign corporation (CFC) for derivatives commodities” (for example, interest rates, trading;32 exchange rates, currencies and debt or equity instruments)29 are still subject to the defini- • Whether the fund’s marketing materials tion of “bona fide hedging” contained in (including the fund’s prospectus and/or

5 Vol. 19, No. 5 • May 2011 disclosure document) refer to the ben- Internal Revenue Code of 1986 (the Code). efi ts of derivatives or make comparisons In 2005, the Internal Revenue Service (IRS) to a derivatives index; issued a revenue ruling that concluded that income and gains from certain commodity- • Whether the fund has a net short spec- linked derivatives are not “qualifying income” ulative exposure to any commodity under Subchapter M of the Code. As a result, through derivatives investment during a fund’s ability to invest directly in commod- the course of its normal trading activi- ity-linked swaps as part of its investment strat- ties; and egy is limited by the requirement that it receive no more than 10 percent of its gross income • Whether derivatives transactions will be from such investments. Beginning in 2006, the the primary source of the fund’s gains IRS has issued private letter rulings to certain and losses. 33 funds indicating that the income derived from a fund’s investments in a CFC will constitute The CFTC indicated that it will give more “qualifying income” to the fund, even if the weight to the final factor in the list when CFC itself owns commodity-linked swaps. determining whether a mutual fund is operat- Accordingly, many funds have established ing as a de facto commodity pool. The CFTC CFCs through which the funds obtain their indicated that violations will be determined on exposure to commodities that do not produce a case-by-case basis, depending on the particu- “qualifying income” under Subchapter M of lar facts and circumstances. the Code. The IRS, however, has stopped issu- As noted by many industry commentators, ing such rulings. CFCs are typically structured the marketing restriction under Rule 4.5, as as offshore vehicles that are wholly-owned by drafted, introduces a level of uncertainty and the fund. A fund generally is not permitted to an opportunity for second-guessing as to a invest more than 25 percent of its assets in any fund’s proper status under Rule 4.5. If the one issuer under Subchapter M diversification CFTC takes a broad interpretation of the requirements. As a result, funds are able to marketing restriction, such restriction could only invest 25 percent of their total assets in effectively eliminate the benefit of limiting a CFC. trading to meet the de minimis thresholds In the Adopting Release, the CFTC under Rule 4.5. The only comfort provided addressed the application of Rule 4.5 by the CFTC thus far has been the following with respect to mutual funds investing in statement included in the Adopting Release: commodities through a CFC.35 Although the “[The CFTC] will not consider the mere CFTC indicated that it was not opposed to the disclosure to investors or potential investors continued use of CFCs by funds, the CFTC that the registered investment company may made clear that a CFC that is engaging in engage in derivatives trading incidental to its commodity trading is itself a commodity pool main investment strategy and the risks associ- and, accordingly, persons operating a CFC ated therewith as being violative of the mar- must register as CPOs unless they qualify for keting restriction.”34 Accordingly, a general an exemption “on their own merits.”36 The statement that the fund may invest in futures CFTC stated that a CFC must be assessed on and swaps should not violate the marketing its own characteristics and that a CFC is not restriction set forth in Rule 4.5. entitled to exclusion under Rule 4.5 because its parent company is a mutual fund that may be 37 Application of Rule 4.5 to a Mutual entitled to exclusion. As a result of the above, it is likely that most Fund’s Use of a Controlled Foreign operators of mutual fund CFCs used for com- Corporation (CFC) modity investing will be required to register as A fund must derive at least 90 percent CPOs, although, in most instances, such per- of its gross income from certain qualify- sons will be subject to a reduced compliance ing sources of income in order to qualify as burden with respect to the CFC.38 It is too a regulated investment company under the early to predict whether the CFTC registration

THE INVESTMENT LAWYER 6 rules will negatively affect mutual funds’ use recognized that requiring trustees or direc- of CFCs to obtain commodities exposure. tors to register as CPOs “would raise opera- The decision to discontinue the use of CFCs tional concerns for the registered investment will likely be made by each investment adviser company as it would result in piercing the individually after evaluating the overall impact limitation on liability for actions undertaken of Rule 4.5 with respect to all mutual funds in the capacity as director.”40 As a result, and accounts advised by such adviser. One the CFTC concluded that the investment possible set of beneficiaries of the new CFTC adviser for the fund is the entity required to rules are the issuers of commodity-linked register as the CPO.41 Notwithstanding this notes. As a possible alternative to the use of fact, fund boards will want to discuss the a CFC, funds may seek to increase their use implications of being subject to the CFTC of IRS-approved commodity-linked notes in regulatory regime with their D&O/E&O and an attempt to gain commodities exposure and fidelity bond insurance providers. Further, avoid CPO registration requirements. fund boards may want to have their counsel On a related topic, in the Adopting review (i) the indemnification provisions Release the CFTC discussed certain unique in their governing documents to identify issues surrounding Rule 4.5 related to funds any possible gaps with respect to indem- of funds. Relying on the fact that the statu- nifiable acts, and (ii) fund service provider tory definition of “commodity pool” does agreements to identify any possible gaps in not distinguish between direct and indi- services, including compliance monitoring, rect investments in commodity interests, the required to be performed in light of the new CFTC stated that a fund that invests in CFTC regulations. an unaffiliated commodity pool is itself a The CFTC did not specifically address the commodity pool for purposes of the CEA registration implications of advisers who act and the CFTC’s rules.39 The CFTC further as managers-of-managers for their funds (that noted that allowing an exemption for indirect is, advisers who hire and oversee sub-advisers investments in commodity interests would who, in turn, manage the day-to-day invest- create an incentive for entities to avoid direct ment of the fund’s portfolio). In this situation, investments in commodity interests to, in we would expect the adviser to be the appro- turn, avoid registration as CPOs. This guid- priate entity to register as the CPO for the ance may cause mutual funds that currently fund and not the individual sub-advisers. The invest in other mutual funds or ETFs (rather sub-advisers, however, will likely be required than CFCs) in order to gain exposure to the to register as CTAs. commodities markets to reevaluate this prac- The above “decision tree” may provide tice to determine whether the practice has useful guidance to funds when determining implications under Rule 4.5. whether registration under Rule 4.5 is required.

Who Will Register? Registration Deadline and Annual The issuance of the Proposing Release Notice Filing Requirement sparked considerable discussion in the fund If a mutual fund has not filed a Rule 4.5 industry regarding the appropriate entity notice with the NFA prior to April 24, 2012, that would be required to register as a CPO if then the investment adviser to such fund is the mutual fund could not qualify for exclu- required to register as a CPO at that date sion under Rule 4.5. Many in the industry unless the adviser is entitled to an exclusion were concerned that a registered investment under amended Rule 4.5. With respect to company’s board of trustees or directors mutual funds that have filed Rule 4.5 notices would be required to register. Accordingly, with the NFA prior to April 24, 2012, invest- many fund industry participants urged the ment advisers to such funds that are required CFTC to make clear that the investment to register as CPOs as a result of changes in adviser to the fund would be the person Rule 4.5 must become registered by the later required to register as the CPO. The CFTC of December 31, 2012 or 60 days after the

7 Vol. 19, No. 5 • May 2011 Is your Investment Company a Commodity Pool?

Does the Investment Company trade Does the Investment Company invest in another “Commodity Interests?” fund that trades “Commodity Interests?”

Futures or Swaps (Commodity Swaps, Futures or Swaps (Commodity Swaps, including commodity options). including commodity options). “Commodity” is very broad and includes, in “Commodity” is very broad and includes, in addition to metals, agricultural and energy addition to metals, agricultural and energy products, financials, such as interest rates, products, financials, such as interest rates, currencies (including NDFs) and broad-based currencies (including NDFs) and broad-based indices such as equity and CDS indices). indices such as equity and CDS indices).

Yes

Your Investment Company is a Commodity Pool

Are You a Commodity Pool Operator?

Does the Investment Company Is the net notional value of the devote 5% or more of its NAV to Investment Company’s initial margin or option premiums commodity interests, excluding for commodity interests, excluding bona fide hedging, in excess of bona fide hedging? 100% of its NAV?

No No

Is the investment company marketed as a commodity pool or as a vehicle for trading in commodity interests?

Yes Yes Yes

You are a Commodity Pool Operator and must register with the CFTC effective date of the final rulemaking by the Previously, Rule 4.5 required persons claim- CFTC defining the term “swap” and estab- ing relief from registration with the CFTC to lishing margin requirements for swap posi- electronically file with the NFA a notice claim- tions.42 The CFTC expressly rejected requests ing such exemption only once at the inception from commenters that would grandfather of the fund. As amended, however, Rule 4.5 existing fund advisers out of the new regula- requires that on an annual basis, in order to tory framework. Once an investment adviser retain eligibility for the exemption, persons is registered as a CPO for a registered invest- who are still eligible for relief under Rule 4.5 ment company, it will not be required to com- must affirm the accuracy of their original ply with the CFTC’s recordkeeping, reporting, notice of exemption, withdraw such exemption and disclosure requirements until 60 days if they cease to conduct activities requiring after the adoption of final rules implement- registration or exemption from registration, or ing the CFTC harmonization rules discussed withdraw the exemption and apply for registra- below. tion within 60 days of the calendar year end.

THE INVESTMENT LAWYER 8 Implications of Registration as a CPO by other fund service providers (for example, sub-advisers, administrators, distributors or It is expected that the revisions to CFTC custodians), the adviser should seek to enter Rule 4.5 will cause a significant number of into agreements with such service providers investment advisers to register as CPOs with that provide the adviser with indemnification respect to certain of the mutual funds they and contribution for such acts. The extent to manage. Funds that use commodities for non- which the remedies provided to participants in bona fide hedging purposes above a de minimis commodity pools under the CEA and CFTC amount, funds that use CFCs, and funds that rules differ from those provided to fund share- provide significant commodities exposure and holders under the 1940 Act, the 1933 Act, and market themselves as such (which include many the 1934 Act should also be analyzed by both ETFs) are directly in the cross-hairs of the new advisers and funds. Finally, investment advis- regulations. Investment advisers to these funds ers registering as CPOs with respect to their should begin to review the CPO registration mutual funds should review, among other process in an effort to become familiar with the things, their investment advisory agreements process and the consequences of registration. with their funds and their directors’ and offi- Registration as a CPO is a relatively involved cers’ (D&O) insurance policies to determine process and typically takes from six to eight whether changes are appropriate in light of weeks to complete. Registration involves sub- this additional layer of liability.46 mission of Form 7-R for the CPO and Forms Advisers that will be required to register 8-R for all natural person principals and for as CPOs with respect to registered investment all associated persons (APs), along with fin- companies will also have to file Form CPO- gerprints for such principals and APs, as well PQR with the NFA, which is a commodity as proof that each AP passed the required pool’s quarterly report. 47 Form CPO-PQR proficiency exams (generally the Series 3).43 requires disclosure of extensive information At least one principal will be required to be about each pool operated by a CPO, the registered as an AP. CPO itself, and third-party service providers. Advisers registering as CPOs with respect CPOs will also be required to provide state- to their funds will be subject to additional ments about changes in the pool’s assets potential regulatory and shareholder liability. under management, monthly rates of return, Registered CPOs are subject to punitive or and subscription and redemption activ- remedial action from the CFTC and could ity. Extensive financial and risk information have their CFTC registration revoked or must also be disclosed on a quarterly basis. denied for violations of the CEA or CFTC Depending on the size of assets under manage- regulations. Investors in a fund that qualifies ment by the CPO, reporting requirements may as a commodity pool under Rule 4.5 will have increase or decrease. Also, for those advisers access to the CFTC’s reparations program that also manage private funds, Form CPO- and NFA’s arbitration program. 44 Further, PQR is in addition to (and not instead of) any registered CPOs will have liability for viola- reporting requirements imposed by Form PF. tions of the CEA by the CPO and the fund. However, the CFTC indicated in the Adopting In this regard, advisers should review whether Release that it intends to amend Rule 4.27 so CPO registration will cause the adviser to be that dual registrants filing Form PF would not primarily liable for the fund’s disclosure docu- need to file Schedules B and C to Form CPO- ments filed with the CFTC or whether the PQR.48 Further complicating compliance recent US Supreme Court decision in Janus for those advisers, assets under management Capital Group, Inc. v. First Derivative Traders must be calculated in different ways for Form will continue to protect the adviser from pri- PF and Form CPO-PQR and the forms are mary liability. 45 Further, to the extent there required to be filed on different timelines. As is a risk that the CFTC will hold the adviser a result, it is expected that Form CPO-PQR of the fund (that is, the registered CPO of the will be a significant undertaking for advisers’ fund) responsible for violations of the CEA fund accounting, administration and compli- and CFTC rules by the fund that are caused ance departments, particularly considering the

9 Vol. 19, No. 5 • May 2011 overlap with other recently enacted regulatory registration statement under the 1933 Act reporting requirements such as Form PF and to claim relief from, among other require- amendments to Form ADV. 49 ments, the disclosure document delivery and acknowledgement requirements under Rule Harmonization of SEC 4.21. Currently, CFTC Rule 4.12(c), which and CFTC Regulations was adopted to provide compliance relief to ETFs, is available only to CPOs of pools Parallel to the release adopting amend- whose interests are both offered and sold ments to Rule 4.5, the CFTC on February 9, pursuant to an effective registration statement 2012 also proposed rulemaking intended to under the 1933 Act and listed for trading on harmonize certain CFTC- and SEC-imposed a national securities exchange registered as compliance requirements in an effort to such under the 1934 Act. However, in the mitigate the burden on mutual funds with Harmonization Release, the CFTC noted that respect to complying with the two similar, but “there is no useful distinction between pub- separate, compliance regimes (the Proposed licly offered pools whose units are listed for Rules).50 The Proposed Rules address each trading on a national securities exchange, and of the harmonization concerns raised by the those which are not.”53 NFA in its comment letter to the CFTC51 The relief provided by Rule 4.12(c) is sub- and focus on the harmonization of certain ject to certain conditions, including that the requirements in three key areas: disclosure CPO make the disclosure document readily documents, periodic reports, and recordkeep- accessible on its website, which would effec- ing. Advisers to funds that will be required tively require any mutual fund complexes to register as CPOs should keep a close eye without public websites to create websites in on the development of the Proposed Rules. order to avoid costly delivery requirements. Comments on the Proposed Rules were due to Further, Rule 4.12(c) would require funds the CFTC by April 24.52 to inform shareholders of the address of this website and instruct fund intermediaries Harmonization of Disclosure Documents to do the same. In addition, to rely on the exemptive relief provided by Rule 4.12(c), a Delivery Requirement. CFTC Rule 4.21 registered investment company and its CPO currently requires a CPO to deliver a dis- must file a notice of claim for exemption with closure document prepared in accordance the NFA consistent with the requirements of with CFTC Rules 4.24 and 4.25 to each Rule 4.12(d). prospective investor in the pool by no later Break-Even Point and Fees and Expenses than the time it delivers to the prospective Disclosure. Rather than prepare both a investor a subscription agreement for the prospectus and an SAI to be filed with the pool. CFTC Rule 4.21 further requires that SEC and a separate disclosure document to a CPO not accept or receive funds, securities, be filed with the NFA, the Proposed Rules or other property from a prospective investor would permit registered investment compa- unless the CPO first receives a signed and nies no longer able to rely on Rule 4.5 to dated acknowledgement from the prospective include CFTC-required disclosures in their investor stating that he or she received the Form N-1A filings.54 The Proposed Rules con- disclosure document. template that registered open-end investment In response to comments that these require- companies would present in their prospectus, ments are at odds with prospectus delivery following the summary section, a tabular requirements applicable to registered invest- presentation of the calculation of the regis- ment companies under Section 5(b)(2) of the tered investment company’s break-even point 1933 Act and would generally preclude fund required by CFTC Rule 4.24. The break-even distribution through certain platforms, the analysis is an illustration of the trading profit CFTC proposes to amend Rule 4.12(c) to that the fund must realize during the first year permit the CPO of any pool whose interests after a shareholder’s investment such that the are offered and sold pursuant to an effective shareholder would recoup his or her initial

THE INVESTMENT LAWYER 10 investment, which is calculated both in terms Form N-1A to be included in a fund’s sum- of dollars and a percentage of the minimum mary prospectus, the CFTC showed defer- initial investment. The CFTC noted in the ence to the SEC’s rigid requirement that only Harmonization Release that it views this dis- information required by or permitted by Items closure as “necessary” in that “it mandates 1 through 8 of Form N-1A be included in a greater level of detail regarding brokerage the summary section of a fund’s prospectus. fees and does not assume a specific rate of Accordingly, this should cause a minimal cost return.”55 burden for those funds that have migrated The Proposed Rules also indicate that the to the summary prospectus delivery regime. registered investment company must disclose However, having two different sets of fee all fees and expenses required to be disclosed disclosures in two different places in a fund’s pursuant to CFTC Rule 4.24(i). Certain of the prospectus may appear disjointed and poten- fees required by Rule 4.24(i) are not currently tially confuse investors. In this regard, funds required to be presented separately in a regis- may want to request that the SEC and CFTC tered investment company’s fee table pursuant provide guidance as to how funds can best to Item 3 of Form N-1A, such as: alleviate any potential shareholder confusion regarding how the two sets of fee disclosures • Brokerage fees and commissions; fit together. Performance. Registered investment com- • Incentive fees (funds are not permit- panies no longer able to rely on Rule 4.5 will ted to have incentive advisory fees un- be required to comply with the performance- less they are structured as fulcrum fees, reporting requirements of Rule 4.25 in their which already would be included in the disclosure documents. While certain of the fund’s fee table); CFTC performance-reporting requirements overlap with those required by the SEC and • Commissions or other benefits in con- federal securities laws, others do not. Most nection with the solicitation of partici- notably, Rule 4.25(c) requires commodity pations in the pool (funds are permitted pools that have less than a three-year oper- to charge sales loads and make pay- ating history to disclose the performance of ments pursuant to a Rule 12b-1 plan, each other pool (including private pools) oper- which already would be included in the ated by the CPO (and the CTA, if applicable) fund’s fee table); and each other account traded by the CPO (and the CTA, if applicable). • Clearance fees and fees paid to national In the Proposed Rules, the CFTC spe- exchanges and self-regulatory organiza- cifically recognizes that such reporting may tions; conflict with the SEC’s position generally prohibiting the use of related account past • For principal-protected pools, any direct performance without substantial disclosure or indirect costs to the pool associated and seeks comment on whether it should try with providing the protection feature; to harmonize its past performance-reporting requirements with the positions of the SEC. • Any costs or fees included in the spread To the extent such performance disclosure between bid and ask prices for retail is required, the CFTC is proposing that the forex transactions; and performance of other pools and accounts may be included in the fund’s SAI instead • Any other direct or indirect cost.56 of its prospectus. Nonetheless, any disclosure in a fund’s SAI regarding a private pool These fees and expenses must be pre- advised by the adviser may jeopardize the sented together with the break-even analysis. private pool’s ability to rely on its private offer- Although the break-even analysis and fees dis- ing exemption under 1933 Act (for example, closure required under the CFTC framework Regulation D) and comply with the private is conceptually similar to the fee table and offering requirements under the 1940 Act (for total annual expense examples required by example, Sections 3(c)(1) and 3(c)(7)). The

11 Vol. 19, No. 5 • May 2011 Harmonization Release notes that the CFTC the fact that funds are continuously offered, has had preliminary discussions with the SEC the CFTC reminded the industry that cur- Staff on the issue of disclosure of past perfor- rent Rule 4.26(d)(2) permits CPOs to provide mance generally, and the SEC Staff has stated updated disclosure documents to pool partic- that it would consider requests for no-action ipants at the same time such updates are filed relief regarding the performance presenta- with the NFA. In this regard, one suggested tions, if necessary and appropriate.57 However, approach outlined in the Harmonization the Harmonization Release does not address Release contemplates that funds will post whether the CFTC and the SEC specifically their updated documents, with any changes discussed the issues surrounding the inclusion highlighted, on their websites at the same of private pool information in a publicly dis- time they file the updated documents with seminated fund offering document. Therefore, the NFA. Then, upon completion of the NFA it would be appropriate for affected advisers review process, funds would post their final to request clarification on this issue from the documents. CFTC and SEC. Although this approach may provide funds Although not addressed in the the flexibility to use offering documents while Harmonization Release, the requirements of still under review by the NFA, funds can expect Rule 4.25(c) also conflict with the Financial to receive two sets of regulatory comments on Industry Regulatory Authority’s (FINRA’s) all prospectus filings and, possibly, NFA com- rules prohibiting broker-dealers from using ments on prospectus supplements. It is not fund sales material that includes the perfor- unreasonable to imagine a situation in which mance of other accounts. Accordingly, funds a fund will be forced to supplement its final should request that the CFTC include FINRA prospectus following its annual update filing in their discussions with the SEC regarding the with the SEC to reflect additional NFA com- harmonized performance disclosure requirements. Alternatively, funds may be forced to ments. consider the feasibility of filing with the NFA Updating Amendments. CFTC Rule 4.26 prior to filing with the SEC documents that requires that a new disclosure document be become immediately effective upon filing with prepared and filed after nine months of use. the SEC. However, a question remains as to In contrast, registered investment companies whether funds will be hesitant to immediately are generally required to update their prospec- print and mail important supplement informa- tuses annually.58 To remedy this inconsistency, tion based on fears that NFA comments on the Proposed Rules would permit CPOs (and the supplement will force the fund to reprint CTAs) to file updates to disclosure documents and re-mail the supplement. In any event, this 12 months from the date of the documents new regulatory review process needs to be fac- being updated. tored into a fund’s filing, printing and offering In addition, generally, CPOs are not permit- schedule, especially when a fund complex is ted to distribute a new or updated disclosure seeking to launch a new product. document until the NFA has reviewed and In light of the proposed requirement to file accepted the disclosure document. Registered offering documents with the NFA, advisers investment companies, on the other hand, and funds should begin to evaluate the feasi- file a registration statement pursuant to Rule bility of, and costs related to, using separate 485(b) under the 1933 Act as part of their offering documents for those funds subject to annual update process that does not require the CFTC rules. Further, in light of the dif- prior review by the SEC and is automati- ferent disclosure requirements that would be cally effective upon filing, unless otherwise applicable to funds subject to the CFTC rules designated. Further, fund supplements filed (for example, break even analysis and more pursuant to Rule 497 under the 1933 Act also expansive fee and expense disclosure), advisers become effective automatically upon filing. and funds should consider whether the inclu- In response to requests from commenters sion of such funds in the same prospectus with that the CFTC should provide funds relief funds not subject to the CFTC rules would from NFA pre-review requirements in light of result in investor confusion.

THE INVESTMENT LAWYER 12 Cautionary Legend. The Proposed Rules certification on periodic and annual reports. also address the legends required by the CFTC CFTC Rule 4.22(h) requires the individual and SEC to be included on the cover pages of making the certification on behalf of the a pool’s disclosure document and a fund’s pro- CPO to make an oath or affirmation that, to spectus, respectively. Instead of including two the best of his or her knowledge and belief, statements on the cover page of a fund’s pro- the information contained therein is accurate spectus that meet the requirements of CFTC and complete. The certification required by Rule 4.24 59 and Rule 481(b)(1) under the 1933 the SEC in a fund’s Form N-CSR (the report- Act, 60 the CFTC proposes that a fund include ing form used by funds for filing their annual a single statement that combines the language and semiannual reports to shareholders with required by both Rule 4.24 and Rule 481(b)(1). the SEC) is similar and tracks the language We would expect this disclosure to be similar of Section 11 of the 1933 Act: “Based on my to the following: knowledge, this report does not contain any untrue statement of a material fact or omit Neither the US Securities and Ex- to state a material fact necessary to make the change Commission nor the Commod- statements made, in light of the circumstances ity Futures Trading Commission has under which such statements were made, not approved or disapproved these secu- misleading with respect to the period covered rities, determined if this prospectus is by this report.” While the CFTC certification truthful or complete, OR passed upon must be included in reports provided to pool the merits of investing in this product. participants, the fund Form N-CSR certifica- Any representation to the contrary is a tion is made available through the EDGAR criminal offense. system, but is not provided to fund shareholders. In the Harmonization Release, the CFTC Harmonization of Periodic Reporting stated that it will “accept the SEC’s certifica- Requirements and Certifi cations tion as meeting the requirement under Rule 4.22(h), as long as such certification is part of CFTC Rule 4.22 requires that a CPO peri- the Form N-CSR filed with the SEC.”61 odically distribute to each investor in each pool it operates an account statement con- Harmonization of Recordkeeping sistent with Rule 4.22. Account statements Requirements must be distributed monthly for pools with net assets of more than $500,000 and at least CFTC Rule 4.23 requires a CPO to make quarterly for all other pools. In the Proposed and keep the requisite books and records Rules, the CFTC recognizes that this require- “at its main business office.” Registered ment may be more burdensome than the semi- investment companies, on the other hand, annual reporting requirement applicable to often maintain their books and records with registered investment companies. Nonetheless, third parties, such as a fund’s administrator, the CFTC does not propose to alter the con- custodian, transfer agent, or investment tent or eliminate the monthly delivery require- adviser. The Proposed Rules would expand ments, in large part because the CFTC believes Rule 4.12(c) to permit registered investment that the information required to prepare the companies and their CPOs to continue to account statement should be readily available maintain their records with third parties sub- to the CPO in accordance with applicable ject to certain conditions. In particular, the recordkeeping requirements. The CFTC’s pro- books and records that the CPO will not posed expansion of the exemption provided keep at its main business office must be main- by Rule 4.12(c), however, would provide relief tained by the registered investment company’s from the monthly delivery requirement so administrator, distributor, or custodian, or a long as the CPO makes such fund information bank or registered broker or dealer acting in available on its website. a similar capacity with respect to the regis- Another area where current SEC and tered investment company. Notably, a fund’s CFTC requirements differ is the required transfer agent and investment sub-adviser

13 Vol. 19, No. 5 • May 2011 and professional storage and maintenance What Should Fund Advisers firms are not included within this list of eli- Be Doing Now? gible recordkeeping entities. We expect fund companies to raise this issue with the CFTC The changes to CFTC Rule 4.5 and related during the comment period. To take advan- rules and the proposed harmonization rules will tage of this relief, in the notice it files with affect most advisers to registered investment com- the NFA, the CPO must specify the books panies. Between now and December, such advis- and records that each person will be keeping ers should, at a minimum, take the following and make certain representations, including steps: that it will promptly amend the statement if the contact information or location of any of • Take an inventory of all of their regis- the books and records required to be kept by tered fund offerings, noting levels of Rule 4.23 changes, and disclose in the pool’s commodity use, including swaps, and disclosure document the location of its books those funds that use CFCs; and records that are required under Rule 4.23. • Evaluate levels of commodity use in CFTC Sought Additional Comment on connection with the de minimis tests; Areas in Need of Harmonization • For those advisers with funds near the In the Harmonization Release, the CFTC thresholds for commodity pool registra- sought comment on several areas, including tion, review the two trading thresholds whether there are other provisions of Part 4 set forth in Rule 4.5 and the bona fide of the CFTC’s regulations that might require hedging exemption to determine wheth- harmonization and whether the CFTC’s pro- er procedures could be implemented to posals regarding break-even analysis and per- ensure that the pools remain below these formance reporting strike the right balance limits so that the advisers would not between providing material information and need to register as CPOs; reducing conflicting or duplicative disclosure obligations imposed on funds. In recogni- • Review the extent to which CPO regis- tion of the NFA’s suggestion that the CFTC tration implicates additional liability for “consider granting similar relief to public the adviser, and review the firm’s insur- commodity pools to avoid giving one structure ance coverage; a competitive advantage over other similar structures in the marketplace,”62 the CFTC • Review fund disclosure documents, also sought comment as to whether the pro- marketing materials, and fund names posed harmonization provisions should be to ensure that those funds that meet applied to operators of pools that are not reg- the thresholds for exclusion do not istered investment companies. otherwise trigger CPO registration re- The Proposed Rules are promising for reg- quirements in light of the marketing re- istered investment companies now faced with striction imposed under Rule 4.5; complying with the CFTC’s regulatory regime, but it seems likely that other conflicts between • Review each fund’s website to ensure the requirements of the two regulatory regimes that the fund is capable of complying will surface once registered investment compa- with any new posting obligations that nies and their CPOs begin to prepare their may be required under the proposed new hybrid prospectus-disclosure document. harmonization rules; In any event, registered investment companies that are unable to avail themselves of the • Begin considering the disclosure and de- revised Rule 4.5 exemption will likely face sig- livery implications of the proposed har- nificant costs associated with interpreting and monization rules, including the calcula- drafting their initial filings under the newly tion of a break-even analysis, disclosure adopted dual regulatory framework. of additional fund fees, disclosure of

THE INVESTMENT LAWYER 14 past performance for funds with fewer 9. When claiming the Rule 4.5 exclusion, a fund was than three years of operations, and web- required to represent to the CFTC that (i) the fund will site posting of information; and disclose in writing to each participant, whether existing or prospective, that the fund has claimed an exclusion from the definition of the term “commodity pool • Review the reporting requirements of operator” under the CEA and, therefore, is not subject Form CPO-PQR to ensure that their to registration or regulation as a pool operator under the systems are set up to capture the neces- CEA; and (ii) such disclosure will be made in accordance sary information. with the requirements of any federal or state regulatory authority to which the fund is subject. In most instances, funds included this disclosure in their Statements of Additional Information (SAIs). Funds were also required Notes to submit to special calls from the CFTC in order to 1. For ease of reference, this article may use the term demonstrate their compliance with the provisions of Rule “mutual fund” or “fund” to refer to an open-end manage- 4.5. For a discussion of the coverage requirements under ment investment company (or series thereof) registered the Investment Company Act, see Securities Trading under the Investment Company Act of 1940. The new Practices of Registered Investment Companies , Investment rules discussed herein, however, apply equally to regis- Company Act Rel. No. 10,666, 44 Fed. Reg. 25,128, 25,129 tered closed-end investment companies and exchange- (Apr. 18, 1979). See also Georgia Bullitt, et al., “Legal traded funds that have registered as unit investment Considerations for Registered Investment Companies trusts. Investing in Derivatives,” The Investment Lawyer (Aug. 2010 and Oct. 2010). 2 . See Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations, 10. See SEC Staff Evaluating the Use of Derivatives by 77 Fed. Reg. 11,252 (Feb. 24, 2012) (hereinafter, Adopting Funds, SEC Release 2010-45 (Mar. 25, 2010), available at Release). See also Commodity Pool Operators and http://www.sec.gov/news/press/2010/2010-45.htm; see also, Commodity Trading Advisors: Amendments to Compliance Bullitt, et al., supra n.9. Obligations, 76 Fed. Reg. 7976 (Feb. 11, 2011) (hereinafter, 11. See Letter from Mr. Thomas W. Sexton, III of NFA Proposing Release). to Mr. David A. Stawick of CFTC (Aug. 18, 2010), 3 . See Section 1a(10) of the CEA and CFTC Rule 4.10(d) available at http://www.nfa.futures.org/news/newsPetition (1). Commodity interests include futures contracts, options .asp?ArticleID=3630 . on futures contracts, security futures, swaps, certain foreign exchange and commodity options. 12. In a comment letter, however, the NFA suggested broadening the scope of the coverage to apply the same 4 . See 7 U.S.C. § 1a(11). types of limits on banks and trust companies as the revised rule does on registered investment companies. 5 . See Commodity Pool Operators and Commodity See Letter from Thomas W. Sexton, III of NFA to David Trading Advisors; Exemption From Registration and From A. Stawick of CFTC, Re: Commodity Pool Operators Subpart B of Part 4 for Certain Otherwise Regulated and Commodity Trading Advisors: Amendments to Persons and Other Regulatory Requirements, 49 Fed. Reg. Compliance Obligations (Apr. 12, 2011). 4778-02 (Feb. 8, 1984); CFTC Interpretive Letter No. 96-76 n.3 (Oct. 21, 1996), available at http://www.cftc.gov/ucm 13. Adopting Release, supra n.2 at 11,254. See also /groups/public/@lrlettergeneral/documents/letter/96-76.pdf. Proposing Release, supra n.2 at 7984. 6. Banks, benefit plans, and insurance companies cur- 14. See Adopting Release, supra n.2 at 11,255. rently relying on the exemption are unaffected by the recent amendments to Rule 4.5 and may continue to con- 15. Bona fide hedging is further discussed below. duct their commodity pool businesses without registration. These regulated entities, however, will be subject to the 16. Under the final rules for determining the “net notional marketing restriction and the annual notice requirement, value,” the registered investment company may net futures discussed below. contracts with the same underlying commodity across designated contract markets and foreign boards of trade and 7. Bona fide hedging transactions and positions are swaps cleared on the same derivatives clearing organiza- defined at CFTC Rules 1.3(z) and 1.51, as further dis- tion. cussed below. 17. Although the Adopting Release clearly indicates that 8 . See Additional Registration and Other Regulatory the net notional test in Rule 4.5 was intended by the CFTC Relief for Commodity Pool Operators and Commodity to be an alternative trading threshold, the actual text of Trading Advisors; Past Performance Issues, 68 Fed. Reg. Rule 4.5 as originally amended suggested that an entity 47,221 (Aug. 8, 2003); see also Additional Registration and must satisfy both trading thresholds in order to rely on the Other Regulatory Relief for Commodity Pool Operators and Rule 4.5 exclusion. On March 26, 2012, the CFTC pub- Commodity Trading Advisors, 68 Fed. Reg. 12,622 (Mar. lished clarifying changes to the amended rules that make 17, 2003). it clear that only one of the thresholds must be satisfied

15 Vol. 19, No. 5 • May 2011 by entities relying on the amended Rule 4.5 exclusion. 4a(c)(2), which directs the CFTC to define what constitutes See Commodity Pool Operators and Commodity Trading a bona fide hedging transaction or position as a transac- Advisors: Compliance Obligations, 77 Fed. Reg. 17,328 tion or position within a certain framework. In January (Mar. 26, 2012). 2011, the CFTC proposed, and in November 2011 the CFTC adopted, Rule 151.5 pursuant to this authority, 18. For futures contracts, notional value is calculated by which sets forth a definition of “bona fide hedging.” See multiplying the size of a futures contract expressed in con- Position Limits for Futures and Swaps , 76 Fed. Reg. 71,626 tract units by the current market price per unit of the con- (Nov. 11, 2011). tract (e.g ., contracts on stock indices are generally in units of a certain dollar amount times the price of the index) 27. See Adopting Release, supra n.2 at 11,256 n.49. by the number of contracts held. For options on futures 28. See Position Limits for Futures and Swaps, supra n.26. contracts, notional value is calculated by multiplying the number of contracts on which the pool has an option by 29. See 7 U.S.C. §1a(19). the size of the contracts expressed in contract units, and adjusted by its delta, by the strike price of the option per 30. See Position Limits for Futures and Swaps, supra n.26 unit. For retail forex transactions, notional value is calcu- at 71,643. lated by calculating the value in US dollars for such transac- 31. As proposed by the CFTC, the marketing restriction tion at the time the transaction was established, excluding would have prohibited the marketing of interests in the for this purpose the value in US dollars of offsetting long registered investment company “as a vehicle for trading and short transactions. The notional value of swaps will be in (or otherwise seeking investment exposure to) the com- determined consistent with the provisions of 17 C.F.R. part modity futures, commodity options, or swaps markets.” 45. We note, however, that 17 C.F.R. part 45 presently does The CFTC agreed with industry comments that the clause not address the determination of notional value of swaps. “or otherwise seeking investment exposure to” created uncertainty in its application and, therefore, removed this 19. See Adopting Release, supra n.2 at 11,263. clause. 20. See id. at 11,257 (“The [CFTC] does not believe that 32. With respect to its reasoning for deeming the use of a it is proper to exclude from the [CFTC’s] oversight those CFC to be an appropriate factor in determining whether entities that are using an index or other so-called ‘passive’ the registered investment company violates the market- means to track the value of other derivatives. Establishing ing restriction, the CFTC noted in the Adopting Release ‘active’ versus ‘passive’ use of derivatives as a criterion that a registered investment company’s use of a CFC for entitlement to the exclusion would introduce an ele- may indicate that the company is engaging in derivatives ment of subjectivity to an otherwise objective standard trading in excess of the trading threshold given that most and make the threshold more difficult to interpret, apply, funds use CFCs to invest up to 25% of their assets in and enforce. It also could have the undesirable effect of derivatives. encouraging funds to structure their investment activities to avoid regulation. Moreover, the use of an index or other 33. See Adopting Release, supra n.2 at 11259. passive investment vehicle by a large number of investment 34. Adopting Release, supra n.2, at 11,259. companies can amplify the market assumptions built into an index or other vehicle.”). 35. Although in mid-2011 the IRS stopped issuing private letter rulings on mutual funds investing in CFCs 21. See Transcript of CFTC Staff Roundtable that invest in commodities and commodity-linked deriva- Discussion on Proposed Changes to Registration and tives (and such rulings were the topic of a recent Senate Compliance Regime for Commodity Pool Operators and hearing), we expect that mutual funds will continue to Commodity Trading Advisors (Roundtable Transcript), invest in commodities and commodity-linked derivatives at 19, 25, 30, 76-77, 87-90, available at http://www.cftc through appropriately operated and structured CFCs until .gov/ucm/groups/public/@swaps/documents/dfsubmission such time as the IRS issues guidance to the contrary or /dfsubmission27_070611-trans.pdf . Congress passes legislation to limit or eliminate such activ- 22. See Notice of Proposed Determination on Foreign ity. Exchange Swaps and Foreign Exchange Forwards Under 36. See Adopting Release, supra n.2 at 11,260. the Commodity Exchange Act, 76 Fed. Reg. 25,774 (May 5, 2011). 37. See id. 23. See, e.g. , Roundtable Transcript, supra n.21 at 69-70. 38. Prior to the Adopting Release, investment advisers that advised both a registered investment company and 24. See id. at 69-71. the registered investment company’s wholly owned CFC 25. See, e.g. , Letter from Ms. Karrie McMillan of the typically relied on an exemption from registration as a Investment Company Institute to Mr. David A. Stawick of CPO provided by CFTC Rule 4.13(a)(4). Because the CFTC (Apr. 12, 2011). Adopting Release also rescinded Rule 4.13(a)(4), these registered investment advisers will be required to register 26. See CFTC Rule 4.5(c)(2)(iii). “Bona fide hedging” is as CPOs or CTAs with respect to the CFC as well as the defined in CFTC Rules 1.3(z)(1) and 151.5. Section 737 parent registered investment company. However, as CPO of the Dodd-Frank Act amended the CEA to add Section to the CFC and the parent registered investment company,

THE INVESTMENT LAWYER 16 the CPO will not be required to prepare for the CFC and 45. See No. 09-525, slip op. 564 U.S. ___ (June 13, 2011). provide to the registered investment company a disclosure On June 13, 2011, the US Supreme Court, in a 5-4 ruling, document, monthly account statements, or annual reports held that a mutual fund adviser and its parent could not because CFTC Rules 4.21(a)(2), 4.22(a)(4), and 4.22(c) be held liable in a private suit under Rule 10b-5 under (8), respectively, each exclude compliance with respect to a the 1934 Act for allegedly false statements contained in a commodity pool operated by a CPO that is the same as or mutual fund prospectus, because the mutual fund itself, that controls, is controlled by, or is under common control rather than the adviser, “made” the statements in the with the CPO of the offered pool. If the CPOs of the CFC prospectus. In summary, the Court held that the “maker” and the parent registered investment company are unre- of a statement for purposes of Rule 10b-5 liability is the lated entities, the CPO to the CFC may still be able to rely person or entity “with ultimate authority over the state- on the relief from certain obligations imposed by Part 4 of ment, including its content and whether and how to com- the general regulations under the CEA provided by CFTC municate it.” Applying this rule to the facts underlying the Rule 4.7. case, the Court held that neither the adviser nor its parent company was the “maker” of the statements in any of 39. See Adopting Release, supra n.2, at 11,264. the fund prospectuses, notwithstanding that the adviser 40. Id. at 11,259. It should be noted, however, that the assisted with their preparation, because the fund itself had CFTC did not provide formal guidance indicating that ultimate authority over the statements as they were filed directors or trustees of nonregistered investment company with the SEC. entities (e.g ., CFCs) were not required to individually register as CPOs if such entities are subject to CPO registration. 46. This review should also be undertaken with regard to any CFC managed by the adviser. 41. Rule 4.14(a)(4) provides that a person is not required to register as a CTA with respect to a pool if such person is 47. See CFTC Rule 4.27, as amended by the Adopting registered as a CPO with respect such pool. Accordingly, if Release. an investment adviser is required to register as a CPO with 48. See Adopting Release, supra n.2, at 11,267. respect to a fund due to the amendments to Rule 4.5, the adviser would not need to register as a CTA with respect 49. Despite requests from commenters, the CFTC also to the fund. declined to lessen the reporting obligations under Form 42. Section 712 of the Dodd-Frank Act directs the SEC CPO-PQR, even though certain information is already col- and CFTC to jointly define the terms “Swap,” “Security- lected through the CFTC’s large trader reporting system, Based Swap,” and “Security-Based Swap Agreement.” In noting that “the scope of information sought through May 2011, the SEC and CFTC jointly proposed definitions, Forms CPO-PQR and CTA-PR will provide [the CFTC] but, to date, the final definitions have not been adopted. with substantially more detail regarding the activities See Further Definition of “Swap,” “Security-Based Swap,” of entities engaged in derivatives trading and will better and “Security-Based Swap Agreement”; Mixed Swaps; enable it to assess the risk posed by a pool or CPO as a Security-Based Swap Agreement Recordkeeping , 76 Fed. whole.” Adopting Release, supra n.2, at 11,268. In addi- Reg. 29,818 (May 23, 2011). The SEC has indicated that it tion, the CFTC declined to lessen the reporting obligations expects product definitions required by Section 712 of the under Form CPO-PQR even though certain requested Dodd-Frank Act to be in place by June 2012. The CFTC information is duplicative of the information funds report had listed “product definitions” on its rule-writing sched- on Form N-SAR with the SEC. ule from January to March 2012. As of the time this article 50. See Harmonization of Compliance Obligations for went to print, such definitions had not yet been adopted. Registered Investment Companies Required To Register as 43. Status as a principal or AP is determined by the Commodity Pool Operators, 77 Fed. Reg. 11,345 (Feb. 24, definitions set forth by the CFTC. An individual’s status 2012) (hereinafter Harmonization Release). as a principal of a CPO would be determined by the individual’s: (1) ability to control the CPO’s business activities; 51. Comment Letter, dated April 12, 2011, to David A. (2) formal title or position with the CPO; and (3) financial Stawick, Secretary of the CFTC, from the NFA Regarding or ownership interest in the CPO. A company may be a Commodity Pool Operators and Commodity Trading principal of a CPO either because it is a general partner Advisors: Amendments to Compliance Obligations; (if the CPO is organized as a partnership) or because of its Proposed Rule, 76 Fed. Reg. 7976 (Feb. 11, 2011). ownership or financial stake in the CPO. Unlike individu- 52. An investment adviser who is registered as a CPO for als, a company’s status as a principal of a CPO based on a registered investment company that conducts a private ownership or capital contribution is determined solely by offering of its shares ( i.e., the company is only registered its direct relationship with the CPO. An AP generally is under the 1940 Act) may be able to rely on CFTC Rule 4.7 an individual who solicits orders, customers, or customer for relief from the disclosure, recordkeeping, and reporting funds (or who supervises persons so engaged) on behalf requirements. In order to rely on this relief, Rule 4.7 of a CPO. An AP is, in effect, anyone who is a salesperson requires that the interests in the fund be offered solely to or who supervises salespersons. See CFTC Rule 3.1(a) “qualified eligible persons” (QEPs) in an offering exempt (definition of principal) and Rule 1.3(aa)(3) (definition of from registration under the 1933 Act. As amended, how- an AP of a CPO). ever, Rule 4.7 would still require the provision of audited 44. See Adopting Release, supra n.2, at 11,254. annual financial statements.

17 Vol. 19, No. 5 • May 2011 53. Harmonization Release, supra n.50, at 11,346. 58. Section 10(a)(3) of the 1933 Act requires that “when a prospectus is used more than nine months after the 54. The Harmonization Release contemplates its appli- effective [date] of the registration statement, the informa- cation to closed-end funds registered on Form N-2 tion contained therein shall be as of a date not more than throughout, which is generally similar to how the sixteen months prior to such use,” which effectively results Proposed Rules would affect open-end investment in an annual updating requirement for Form N-1A regis- companies that file on Form N-1A; however, for pur- trants. poses of this article, we will focus on the application to N-1A registrants (e.g ., mutual funds and ETFs that 59. CFTC Rule 4.24 currently requires a commodity pool are structured as open-end investment management to state on the cover of its Disclosure Document: “The companies). Commodity Futures Trading Commission has not passed upon the merits of participating in this pool nor has the 55. Harmonization Release, supra n.50, at 11,347. Commission passed on the adequacy or accuracy of this 56. Pursuant to Item 3 of Form N-1A, registered disclosure document.” investment companies are required to report “Other Expenses” in their prospectus fee tables. Other Expenses 60. Rule 481 requires a registered investment company include all expenses (except extraordinary expenses) not to state on the cover of its prospectus a legend that indi- otherwise disclosed in the registered investment com- cates that the SEC has not approved or disapproved of pany’s fee table that are deducted from the registered the securities or passed upon the accuracy or adequacy investment company’s assets or charged to all share- of the disclosure in the prospectus and that any contrary holder accounts and reported as expenses in the reg- representation is a criminal offense. Rule 481 provides two istered investment company’s statement of operations. example disclosures. As a result, certain of the fees and expenses required 61. Harmonization Release, supra n.50, at 11,348. by CFTC Rule 4.24(i) may already be included in Other Expenses. 62. Id. Do You Really Want to Do That? IRAs and the 57. See Harmonization Release, supra n.50, at n.30. Prohibited Transaction Provisions

Copyright © 2012 CCH Incorporated. All Rights Reserved Reprinted from The Investment Lawyer May 2012, Volume 19, Number 5, pages 1, 16-32, with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437, www.aspenpublishers.com